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8/21/2019 Cvpjnh mhj jh jh jh jhmhjmhj

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Chapter 5

Revenue

and

costs


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Introduction

Key terms

Equilibriumprice

DemandSide Supply Side

Short run longrun

Revenue

TotalRevenue

AverageRevenue

MarginalRevenue

Cost

Total costAverage

costMarginal

cost

Economiesand

diseconomies


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Key terms

Equilibrium Price:- Price at which quantity

demanded is equal to Quantity supplied.

Demand:- Quantity which a person is ready to

purchase and having need on that particular price

in that particular time period.

Supply:- Quantity of goods which a person is

ready and willing to sell at a given price and at a

given time period.

Cost:- Amount of money spend to produce goods.

Revenue:- Amount of money earned after selling

the production.


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Before starting

revenue and costs

, lets revise

equilibrium price.


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EquilibriumPrice

Price at which quantity demanded and quantitysupplied.

y

xO

D

D

S

S

E

Quantity demanded

and supplied

Price

So, it has both :-

Demand side

Supply side


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So, this chapteris devoted

to a more detailed analysisof the supply sideof the

picture. Both the conceptsrevenue and costsare

related to the supply side.


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Revenue

Earnings of the firmfrom the

sales of its output is called

revenue.

E.g.A seller selling 20 units of the

commodity at Rs. 20 will havetotal revenue as Rs. 400


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Types of revenue

Total

RevenueTotal

earnings

from sales

over a

certainperiod of

time.

TR=P*Q

Average

RevenueRevenue per

unit sold.AR=TR/Q

Marginal

RevenueChange in

revenue

when output

changes by

one unit.MR=TRn+1-

TRn

MR=TR/Y.


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Revenue schedule

Table showingthe relationbetweenoutput and the

revenue(s).


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Revenue scheduleAmount of

outputsold(units)

Price or AR (Rs.) TR (Rs.)

TR=P*Q

MR(Rs.)

MR=TRn+1-TRnMR=

TR/

Y

0 30 0 -

1 29 29 29

2 27 54 25

3 24 72 18

4 20 80 8

5 16 80 0

6 12 72 -8


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Relation between AR and price

AR=TR/Q

AR=P*Q/Q=PSo, ARisnothing but the

priceitself.


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Distinction between demand and revenue

schedule

The demand schedule and the revenueschedules are interlinked. Yet they are not

identical.

Because AR=P, The relationshipbetweenquantity and priceis, of course, the same as

the relationbetween quantity and average

revenue.

We will derive the revenue from the demand

schedule.


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XO

Y

D

D

E

F

A

B

C

H

Quantity

Price

We are given the demand curve

DD for the product a firm.

For drawing the revenue curve,

we have to show the total

revenue at the different levels

of output

At OB, revenue= OA*OB=OAEB

At OH, revenue= OC*OH=OCFH

In this way , from the demand

curve , we can calculate total

revenue at all levels of output.


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Total revenue curve

O X

Y

TR

A

Quantity

Total

revenue

Total revenue rises

when output

increases reaches tothe maximum and

after that start

falling.


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TR and elasticity of demand

Price elasticity of

demand

Price and Quantity

movements (P falls

Q rises)

Change in TR

Elastic (ep>1) % rise in Q > % fall

in P

TR rises

Unitary elastic(ep=1)

% rise in Q > % fallin P

TR remainsunchanged

Inelastic (ep % fall

in P

TR falls


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O

P

Q

Ep =1

Ep=

Ep=0

Ep>1

Ep>1

Quantity

Price

O

P

QQuantity

P

rice

Moreelas

tic

TRrises

Unitary elastic

TR

maximum


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Relation between Total, Average and

Marginal revenue

Relation among TR,AR,MR is shown under two

market situations:-

When the firm

sells its

product at agiven price.

When the firmsells its

product moreat a reducing

price.

Wh h fi ll i d i


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When the firm sells its product at a given

price

Output Price Totalrevenue

Averagerevenue

Marginalrevenue

1 5 5 5 5

2 5 10 5 5

3 5 15 5 5

4 5 20 5 5

5 5 25 5 5

It is called a perfectly competitive market.

Price is determined by industry.

O

Y

X

AR=MR

TR

Quantity

Reve

nue

P

Wh h fi ll i d


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When the firm sells its product more at a

reducing price.

Output Price Total

Revenue

Average

Revenue

Marginal

Revenue

1 10 10 10 10

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

6 5 30 5 0

7 4 28 4 -2

8 3 24 3 -4

O

Y

X

P

TR

AR

MR

TR ismaximum

MR is zero

Output

Reve

nue


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Relation between AR and MR and

Price elasticity of demand Ed= lower portion /

upper portion

=AN/MA

=PO/MP (BPT Theorem)

=PO/AC (MPB ABC)

=AQ/AC

=AR/AR-MR

O

Y

X

M

NQ

P A

C

B

MR

AR=P


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Each firm uses various inputs (resources) in itsproduction activity.

Commonly used inputs: labor and capital

Prices of inputs (wages, rents) Cost of Production

The Cost of Production


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Cost Concepts

Private cost:- the cost of production borne by proprietor or

partners can be termed as private cost. Eg cost of

producing steel by tata steel company.

Social cost:- the sacrifice that the members of society have

to bear for carrying out production. Eg water , air pollution Money cost:- the cost of production which is mesured in

terms of money. E.g. Cost of RAW material.

Real cost:- the cost expressed in terms of the volume of

inputs required to produce a particular quantity of output.


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Explicit and Implicit Costs

Explicit Costs : The money payment that a

firm makes to the outsiders who supply

inputs.These are the out of pocket costs.

Eg. Salaries, price paid for raw material,

components etc.Explicit cost is also known as money cost or

accounting cost.


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Implicit Costs : The costs of the self

owned resources which are employed

by the firm and are nonexpenditure

costs.

Eg. Salary of the proprietor, interest on

the entrepreneurs own investment etc. It is also known as opportunity cost.


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Economic costs

The costs of production which take into

account both explicit cost and opportunity or

implicit costs can be considered as economic

costs of production.

Economic cost= implicit cost + explicit cost+

normal profits


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Normal profit

The normal profit means the minimum

income which accrue to an entrepreneur in

order to induce him for undertaking risk


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Costs that are fixed in the short run may not be

fixed in the long run.

Typically in the long run, most if not all costs are

variable.

Short period and long period


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Short run and long run cost

The short run period implies that period

during which some factors of production

cannot be changed, even with the change in

the level of output.eg land

On the other hand some factors vary with the

variations in the level of output these factors

are called variable factors.e.g raw material ,labour


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30

Types of Costs

Variable Costs

These costs exist only if production occurs.

E.g., fuel for tractor, seed, etc.

Rises when production rises and vice versa.

Also known as prime costs.

Fixed Costs

These cost exist whether production occurs or not.

In the long-run there are no fixed costs.

Can be both cash and non-cash expenses.

E.g., depreciation on tractors and buildings, rent on land etc.

Also known as overhead costs.


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Which costs are variable and which are fixed depends on thetime horizon

Short time horizonmost costs are fixed

Long time horizonmany costs become variable

In determining how changes in production will affect costs, wemust consider if it affects fixed or variable costs

Fixed and variable cost

Total cost


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Total cost.

Some costs vary with output, while some remain the same ,no matter amount ofoutput.

Fixed Cost(FC)cost that does not vary with the level of output.- have to be paid as long as the firm stays in business (even if output is zero)

Variable Cost(VC)cost that varies as the level of output varies.

Total Cost(TC or C)total economic cost of production, consisting of fixed andvariable costs.

TC=FC+VC


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Difference betweenTFC

and TVCTFC

The fixed cost are contractually

fixed. Thus , even if the output

is zero , the firm has to bearthese cos

TFC does not depend on the

level of output. It remain fixed.

TFC does not exist in the longrun.

TFC curve become horizontal.

TVC

The variable cost are

contractually fixed. Thus ,

when the output is zero ,the TVC also become zero.

TVC depends on the level of

output.

TVC exist both during shortrun and long run.

TVC curve takes the shape

of inverted S


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Cost Curves for a Firm

Output

Cost($ peryear)

100

200

300

400

0 1 2 3 4 5 6 7 8 9 10 11 12 13

TVC

Variable costincreases withproduction and

the rate varies withincreasing &

decreasing returns.

TC

Total costis the vertical

sum of FCand VC.

TFC50

Fixed cost does notvary with output


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Shifts of the Cost Curves

Changes in resource prices or technology will cause costs to

change

Cost curves shift

FC increases by 100

Shift of FC curve


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Shift of FC curve

Output

Cost($ peryear)

100

200

300

400

0 1 2 3 4 5 6 7 8 9 10 11 12 13

VC

TC

FC50

FC150

TC

Total costs for firm X


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Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212




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TFC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212




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TFC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212

TVC

(Rs.)

0

1016212840

6091




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TVC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212

TVC

(Rs.)

0

1016212840

6091

TFC




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TVC

TFC

Diminishing marginalreturns set in here




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TVC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212

TVC

(Rs.)

0

1016212840

6091

TFC




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TVC

TFC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212

TVC

(Rs.)

0

1016212840

6091

TC

(Rs.)

12

2228334052

72103




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TC

Output(Q)

0

12345

67

TFC

(Rs.)

12

1212121212

1212

TVC

(Rs.)

0

1016212840

6091

TC

(Rs.)

12

2228334052

72103

TVC

TFC




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TC

TVC

TFC




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46

Recap of TC

Total Fixed Costs (TFC)

The summation of all fixed and sunk costs to production.

Total Variable Costs (TVC)

The summation of all variable costs to production.

Total Costs (TC)

The summation of total fixed and total variable costs.

TC=TFC+TVC

Average Costs


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Average Costs

Average Total costfirms total cost divided by its level of output (average cost per unitof output)

ATC=AC=TC/Q

Average Fixed costfixed cost divided by level of output (fixed cost per unit of output)

AFC=FC/Q

Average variable costvariable cost divided by the level of output.

AVC=VC/Q


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Average Cost

Average Fixed Costs (AFC)

The total fixed costs divided by output.

Average Variable Costs (AVC)

The total variable costs divided by output.

Average Total Costs (ATC)

The total costs divided by output.

The summation of average fixed costs and average variable

costs, i.e., ATC=AFC+AVC.

Summary


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Summary

In the short run, the total cost of any level of output is the sumof fixed and variable costs: TC=FC+VC

Average fixed (AFC), average variable (AVC), and average totalcosts,(ATC) are fixed, variable, and total costs per unit of output;marginalcost is the extra cost of producing 1 more unit of output.

AFC is decreasing

AVC and ATC are U-shaped, reflecting increasing and thendiminishing return

Marginal cost curve (MC) falls and then rises, intersectingboth AVC and ATC at their minimum points.

Marginal Cost change (increase) in cost resulting from the production of


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Marginal Cost change (increase) in cost resulting from the production ofone extra unit of output

Denote - change. For example TC - change in total cost

MC=TC/Q

Example: when 4 units of output are produced, the cost is 80, when 5 units areproduced, the cost is 90. MC=(90-80)/1=10

MC=TVC/Q

since TC=(TFC+TVC) and TFC does not change with Q


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MarginalCost

Marginal Costs

The change in total costs divided by the change in

output.

TC/Y

The change in total variable costs divided by the

change in output.

TVC/Y

Deriving marginal costsCosts (Rs )


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g g

Q TC MC0 12

1 222 283 334 405 526 72

7 103

10657

1220

31

Q

Costs (Rs.)

Deriving marginal costsCosts (Rs.)


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TC

g g

Q TC MC0 12

1 222 283 334 405 526 72

7 103

10657

1220

31

Q

Costs (Rs.)

Costs (Rs.)

Deriving marginal costs


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Q TC MC0 12

1 222 283 334 405 526 72

7 103

10657

1220

31

TC

TC= 12

Q = 1

Q

Costs (Rs.) g g

Costs (Rs.)



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TC

MCDiminishingreturns set

in here

Q

Costs (Rs.) g g

Q TC MC0 12

1 222 283 334 405 526 72

7 103

10657

1220

31

Costs (Rs.)



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MC

Q

Costs (Rs.) g g


A Firms Short Run Costs


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C t C


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Cost Curves

0

20

40

60

80

100

120

0 12

Output (units/yr)

Cost

($/unit)

MC

ATC

AVC

AFC

Marginal Product and Costs


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Marginal Product and Costs

Suppose a firm pays each worker $50 a day.

Units of

Labor

Total

Product

MP VC MC

0 0 0 0

1 10 10 50 5

2 25 15 100 3.33

3 45 20 150 2.5

4 60 15 200 3.33

5 70 10 250 5

6 75 5 300 10

Short-run Costs and Marginal Product


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Short run Costs and Marginal Product

production with one input Llabor; (capital is fixed)

Assume the wage rate (w) is fixed

Variable costs is the per unit cost of extra labor times the amount of extra labor:VC=wL

D Denote - change. For example VC is change in variable cost.

MC=VC/Q ; MC =w/MPL,

where MPL=Q/L

With diminishing marginal returns: marginal cost increases as output increases.


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Short-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC

Total Variable Cost = TVC

TC = TFC + TVC


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Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC = TVC/Q

ATC = AFC + AVC

Marginal Cost = TC/Q = TVC/Q


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Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -

1 60 20 80 $60 $20 $80 $20

2 60 30 90 30 15 45 10

3 60 45 105 20 15 35 15

4 60 80 140 15 20 35 35

5 60 135 195 12 27 39 55


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Relation between average and

marginal costAverage cost

=TC/ QMarginal cost= tc n- tc n-1

Costs (Rs.)


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Q

Q TVC AVCCosts (Rs.)


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0 0 -1 10 102 16 83 21 7

4 28 75 40 86 60 107 91 13

Q

AFC

Q TVC AVCCosts (Rs.)


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3

0 0 -1 10 102 16 83 21 7

4 28 75 40 86 60 107 91 13

Q

AFC

AVC

Q TC ACCosts (Rs.)


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0 121 22 222 28 143 33 11

4 40 105 52 10.46 72 127 103 14.7

Q

AFC

AVC

Q TC ACCosts (Rs.)


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0 121 22 222 28 143 33 11

4 40 105 52 10.46 72 127 103 14.7

Q

AC

AFC

AVC

Q TC MC0 12

Costs (Rs.)


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0 121 222 283 33

4 405 526 727 103

1065

7122031

Q

Q TC MC0 12

Costs (Rs.)


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MC

0 121 222 283 33

4 405 526 727 103

1065

7122031

Q

Q TC MCAC0 12

Costs (Rs.)


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0 121 222 283 33

4 405 526 727 103

1065

7122031

MC-221411

1010.41214.7

Q

Q TC MCAC0 12

Costs (Rs.)


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0 121 222 283 33

4 405 526 727 103

1065

7122031

MC-221411

1010.41214.7

Q

AC

Average and marginal costs


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Output (Q)

Costs

(Rs.)

AFC

AVC

MC

x

AC

z

y

g g


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Long-run costs

Long-run costs

=TC / Q

curves


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curves

OutputO

C

osts

LRAC

Economies of Scale

Alternative long-run average cost


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OutputO

C

osts

LRAC

Diseconomies of Scale

g gcurves

curves


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OutputO

C

osts

LRAC

Constant costs

curves

A typical long-run average cost curve


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OutputO

C

osts

LRAC

A typical long-run average cost curve


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OutputO

C

osts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

Long-run average and marginal costs


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OutputO

C

osts

LRACLRMC

Economies of Scale



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OutputO

C

osts

LRAC

LRMC

Diseconomies of Scale



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OutputO

C

osts

LRAC= LRMC

Constant costs



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OutputO

C

osts

LRMC

LRAC

Initial economies of scale,then diseconomies of scale


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Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q

Long-Run Marginal Cost = LMC = LTC/Q


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Minimizing Costs Internationally

Foreign Sourcing of Inputs

New International Economies of Scale

Immigration of Skilled Labor

Brain Drain


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Long-run costs

Relationship between

short-run and long-runACcurves

Deriving long-run average cost curves: factories of fixed size


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SRAC3

Costs

OutputO

SRAC4

SRAC5

5 factories

4 factories3 factories2 factories

1 factory

SRAC1 SRAC2

Deriving long-run average cost curves: factories of fixed size


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SRAC1

SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Costs

OutputO

Deriving long-run average cost curves: choice of factory size


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Costs

OutputO

Examples of short-runaverage cost curves

Deriving long-run average cost curves: choice of factory size


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LRAC

Costs

OutputO

Relationship Between Long-Run and


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Short-Run Average Cost Curves


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Opportunity costthe value of a highestforgone alternative;cost associated with opportunities that areforgone when a firms resources are not put to

their highest-value use.

Thus we shift some factors of production from one line of production to the other ,

then the amount of output forgone is known as the opportunity cost.

Opportunity Cost


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Opportunity Cost

Opportunity cost what you must give up whenyou make an economic choice.

Example:

I chose the popcorn, so I have to give up the pretzel. That ismy opportunity cost.

Opportunity Cost


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Opportunity Cost

Opportunity costis the best

alternative that we forgo, or

give up, when we make achoice or a decision.

Nearly all decisions involve

trade-offs.

OPPORTUNITY COST DEFINED


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Introduction slide 97

OPPORTUNITY COST DEFINED

The opportunity cost of doing something is whatyou must give up in order to do it.

The cost of a pizza is what you must give up to

consume it, which in this case is easily computed in

money. The cost of a college education includes both money

and other foregone alternatives. For example, the cost

of a year at MSU includes not only tuition and books,

but the income you could have earned working on afull time job.

The cost of attending a Lugnuts baseball game includes

the value of the time you could have spent studying

economics.

The PPC can show opportunity cost


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The PPC can show opportunity cost

Suppose you are at some point on a PPC.

Then suppose you want to consume one more pizza.

The opportunity cost of one more pizza is the

amount of spaghetti you must give up in order to getit.

Note that this opportunity cost is equal to minus the

slope of the PPC.

PRODUCTION POSSIBILITY CURVE


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PRODUCTION POSSIBILITY CURVE

SPAGHETTI

PIZZA

More pizza means less spaghetti

0

100200

300

400

0 10 20 30 40 50 60

OPPORTUNITY COST INCREASES AS


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MORE OF A GOOD IS PRODUCED

Not only does more pizza mean less spaghetti,but each additional pizza costs more than the

one before it.

This idea shows up as the PPC being concave

to the origin. (The curve bows out.)


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Opportunity cost of more pizza is

constant.

Production Possibility Curve

0

100

200300

400

0 10 20 30 40 50 60

SPAGHETTI

PIZZA

Marginal rate of transformation


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(MRT)

The loss in the output of Y for every additionalincrement in the output of X, is considered as

the marginal opportunity cost of X. this is

known as MRT. Marginal opp. Cost=y/ x

Where y= change in the output of Y

x= change in the output of X


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While measuring the MRT , WE CONSIDER THE ABSOLUTE VALUE OF Y/ X

I.E. IGNORING THE - OR + SIGN).THIS IS BECAUSE , WITH AN INCREASE IN MARGINAL COST THE VALUE OF

Y/ X SHOULD RISE


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PRODUCTIO

N OF X

PRODUCTIO

N OF Y

MARGINAL

OPPORTUNITY

COST OF X

0 150

10 140 140-150/10-0=1

20 120 120-140/20-10=2

30 90 90-120/30-20=3

40 50 50-90/40-30=4

50 0 0-50/50-40=5

Y

XO

A

B

C

D


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The ppc becomes concave to the origin due tosuch inceasing mrginal opportunity cost.

IF THE RESOURCE is equally efficient in the

production of both X and Y , then with everyadditional increment in the production of X,

the society always loses a given amount of Y. it

implies constant marginal opportunity cost ofX.

PPC become downward sloping straight line.

Application of opportunity cost


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Since opportunity cost is the cost of the alternative

opportunities foregone , the question of opportunity costsarises in almost every area of economic decision-making.

The concept of opportunity cost applied in the following

fields:-

Planning for national priorities

Making production decisions

Making consumption decisions

Determining the relative price of a commodity

Determining the relative factor price

Determining economic rent of any factors of production.

Opportunity and accounting cost


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Opportunity and accounting cost

Opportunity cost This is an implicit cost.

This shows the probable loss of

income.

This is considered as economiccost.

This is important for making

managerial decisions of a firm.

It shows the currentreplacement value.

The depreciated value of that

machine may not be zero on

the basis of opportunity cost.

Accounting cost This is an explicit cost .

This shows the actual costs of

production.

This is considered as historicalcost or past cost.

This is important for making

financial reports of the firm.

It shows the past value or thehistorical value of the inventories.

The depreciated value of that

machine may be zero on the

basis of accounting cost

Scale of production


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Scale of production

It means the size or volume of production inthe firm.

The actual size of production of a firm is

determined by technological as well as marketforces.

Concept of indivisibility


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Concept of indivisibility

Some factors of production are indivisible i.e.they cannot be used in as small doses as we

like. They come in chunks. Eg.for a farmer the

bullock is indivisible factor because when thefarmer decide to reduce production by half

the bullock cannot be halved.

Economies of scale


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Economies of scale

When the scale of production expands , theproducers reap some benefits . These benefits

reduce their average cost of production .

These are called economies of scale.

Types of economies


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Types of economies

Internal Economies:- the economies enjoyedby a particular firm as a result of expansion of

its own output are called internal economies.

External economies:- when the output of afirm increases the other firms in the industry

also get some advantages. These are called

external economies of scale from the viewpoint of any of the other firm.

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